Secrets of Success: The luck of a successful fund manager

Bill Miller, the American fund manager, had some interesting comments to make again at his recent annual presentation to investors in this country.

Bill Miller, the American fund manager, had some interesting comments to make again at his recent annual presentation to investors in this country. His Legg Mason Value Trust has the distinction - and burden - of being the only mainstream US equity mutual fund to have beaten the S&P 500 index in each of the last 13 years, a record he maintained in 2003, when the fund rose 45 per cent.

Like the England rugby team's recent unbeaten home record, all records of this kind are made to be broken, and academics will rightly point out that Mr Miller's performance is not inconsistent with what you would expect if investment performance were entirely random. After all, a run of 13 odd numbers at roulette is not that rare, even though the odds on any one throw coming up with an odd number are only slightly below 50-50.

Ironically, Miller himself is one of those rare professional investors who happily acknowledges that stock markets in general are pretty efficient, in the academic sense that they discount most available information well. There are not a lot of free lunches around, in other words. He also concedes that you need luck, as well as skill and commitment, in order to put together a record such as his.

His presentation featured a slide which gave some up-to-date figures on the active versus passive argument for US funds. Last year was one year when actively managed general equity funds did outperform the S&P 500 index for a change: 56 per cent beat the market, meaning investors had a slightly better than one in two chance of being in an outperforming fund.

Partly as a result of this good year, over the past five years six in 10 funds have outperformed. But over 10 or 15 years the figure falls back to its long-run average of just 30 per cent (and in practice this figure is probably an exaggeration because it excludes funds that have gone out of business or been liquidated for poor performance).

Interestingly also, the picture is even worse for large-cap funds (i.e those that concentrate on the household names in the broad market indices, such as GE, Microsoft and Coca-Cola). In this case the figures for the proportion of funds that have outperformed are 26 per cent over one year, 38 per cent over five years, 14 per cent over 10 years and 22 per cent over 15 years. What this tells us of course is something that also holds true for the UK market, namely that you have a better chance of beating the market with a small-company or specialist fund than you do with a large-cap fund. One reason why last year was a good one for active managers is that the majority of funds being measured have an above-average exposure to small or medium-cap segments of the market.

It is also logical that as you go down the market capitalisation scale, the more likely it is that a dedicated professional stockpicker will be able to find misvalued shares than is the case in the upper reaches of the market, where the biggest companies are followed by scores of analysts. There is a price to pay for hunting in the lower reaches of the market in the shape of higher risk, higher transaction costs and less liquidity.

Where Mr Miller has an edge, he thinks, is that he is willing to look more deeply into the prospects of companies that the market finds the most difficult to value correctly, and then to hold them for longer periods of time. He has for example been a big shareholder in Amazon, the online retailer, all the way through the internet boom-and-bust years.

Many of his biggest holdings are in technology companies of one kind or another, where Mr Miller has made a strategic decision to see his holdings through to success, despite the inevitable ups and downs along the way. Turnover in his fund is typically much lower than in most actively managed funds, limiting the drag of transaction costs on his returns.

His prediction is that when we come to look back on the first decade of the century, we will see three kinds of share - financials, internet and biotech companies - at the top of the performance tables, just as energy companies dominated the rankings in the 1970s, consumer companies in the 1980s and technology companies in the 1990s. In most cases, sectors that dominate the rankings in one decade do quite well in the early years of the following decade before falling away.

He also makes the point that we can be certain that the upper reaches of the market will be dominated by plenty of different names in 10 years. This is the normal cycle of capitalism at work. Yet it is very difficult for investors today to envisage which the new powers in the indices will be in 10 years, just as the market dominance of (say) Dell and Vodafone was hard to predict 15 years ago.

Mr Miller recalled how back in 1990, as a young fund manager, he wrote a note explaining how overvalued Microsoft was on conventional value measures - p/e ratio, yield and so on. Since then its market value has grown 40-fold. The experience taught him how foolish it was to be hidebound by point-in-time ratios.

Who will be the next Microsoft? That is a good question. One name Mr Miller thinks might make it is eBay, which seems to be emerging as a natural monopoly. He also thinks Amazon could do the same. In a decade when returns in general from shares are likely to be indifferent, and dividend-paying stocks will probably outperform pure growth companies, finding and holding on to the one or two super-growth stocks of tomorrow will be more important than ever if you wish to beat the market averages.

jd@intelligent-investor.co.uk